How do you see the real estate boom and bust cycle before others do? What factors in real estate can you monitor to see if an area is over heating and prices are too high?
It's true, there is a real estate boom and bust cycle at times. It's the nature of the beast in a way, where greed and excess take control and nobody is there to slow the pace of housing creation and lending.
It certainly happened in late 2007, when everyone thought home prices would never go down. However, that was like a 100 year flood, which the real estate market is unlikely to see anytime soon since there are tight regulations and lending standards - well, let's hope.
For the most part, real estate booms and busts are not that severe and often localized. A surge in jobs in one area might cause a housing boom, which can't last forever and will eventually slow down as the real estate market corrects.
Just look at North Dakota and its recent housing boom and bust, due to a rise in oil prices and fracking. But when oil prices dropped, there wasn't a need for so much housing as a lot of the demand slowed. While the Bakken Formation attracted a lot of hydraulic fracturing and horizontal drilling technologies, the cycle peaked and eventually balanced out. When oil prices dropped, so too did the value of real estate in that are. The boom and bust was localized, not spreading to the rest of the country, just to areas that were over built due to the oil drilling and fracking surge.
A real estate boom can be defined as a 30% or greater increase in prices for properties in a 3 year period, with adjustments made to reflect inflation. It is usually agreed that following a real estate boom will come a tapering off period, or a bust.
Although feared by many, this period has actually been relatively mild in the recent past—the market usually becomes stagnant rather than disastrous. In fact, over the last 25 years, no housing bust has seen a 20% or more price drop.
But, if there are low interest rates for an extremely long period of time, and the real estate industry is unregulated, there's a great potential for housing to get out of control. For a landlord though, for an owner of an investment property, while you may lose value on the property itself, if you keep your tenants, you are still generating cash flow even in a down turn in the housing market.
The FDIC (Federal Deposit Insurance Corporation) reports that there is no correlation between boom and bust. Only 9 out of 54 boom instances have been followed by busts within a 5 year time frame. In fact, the FDIC claims that more busts occur in markets that have not experienced booms than in the markets that have.
They concluded that busts are more likely to occur from economic collapse in the local area rather than from an increase in real estate prices. (Consider the down years in the petroleum industry during the late 1980s, when cities such as Midland, TX and Casper, WY, experienced massive housing price drops.)
So even if a nearby area is experiencing a boom, a collapse is not always imminent. But you still need to keep your attention focused on a few things, regardless of how confident and safe you might feel.
Monitor building costs. If the rate to build a home is soaring, then this might be a warning flag that the market is turning into a bubble and that prices are most likely inflated. When there’s a bubble or a surge in real estate prices, contractors might over build in certain areas, hoping to reap the rewards of the market, when in truth the cost to build a home is not nearly as much as the price indicates.
The best way to monitor building costs is to consult with an actual contractor to find out a home’s true cost to build. And remember to never get caught up in “irrational exuberance”—the former Fed Chairman’s phrase for inflated stock prices in the 1990s.
This is also where you revisit several fundamental issues we’ve covered in previous sections of our site. Ask yourself again if the property can pay for itself, and if you will have money left over. (If not, move on to another property, or find out if the seller will reduce the price.) Also, continually ask yourself the questions posed in real estate cycle, regarding the area that you’re currently considering to invest in. These will be issues you’ll constantly be addressing, so never lose sight of them.
Keep an eye on mortgage lending practices. If interest rates climb too quickly, many homeowners could wind up with much larger monthly payments than expected. This will inevitably result in foreclosures and dramatic price drops that can ruin both the homeowner and the investor. Generally speaking, though, this period might be a good opportunity to acquire some quality properties, but you’ll need to tune into the rate of foreclosures, just in case a major bust does occur.
When searching for these homes, the Internet might be your best tool to get you started. You can scour contractors’ websites; conduct a search on a web browser using key words and phrases; look in local newspapers and real estate listings; scan aggregator sites such as www.RealLiving.com or www.move.com; and many other avenues for opportunities abound, such as chat rooms, forums, newsletters, or online publications such as this one: RealEstateJournal.com
Learn more: Property Investing Research